Summary

Interest rates are clearly in a rising regime with rates more than doubling in the last two years.

With rates rising, bond investments are in a pseudo bear market suffering from duration effects.

What is the answer? Should you just forgo bonds?

Investors tend to shun bonds in general either by using a core bond fund or overweighting stocks, which they are more familiar with. But bonds serve a pivotal role including dampening portfolio volatility and allowing the investor to hold through market stress.

Bonds that have a significant amount of interest rate sensitivity (also called duration) are being sold off in favor of less interest rate sensitive investments. But these investments act more like equities with high amounts of credit risks and volatility.

Despite the significant rise in rates since Jan. 1, bonds are only down 1.42% as judged by the Barclay's U.S. Aggregate Index.

Bonds in a Rising Rate Environment

We have discussed in depth how little attention is paid to the bond segments of individuals' portfolios. Our marketplace service was setup to fill that void as we saw so many investors in or near retirement spending countless hours on their stocks but virtually none on their bonds- if they held them at all. The fact that investors- and even financial advisors- spend so much more time on their stocks is not a mystery. Stocks are sexier, easier to understand, and provide the "octane" to the portfolio.

When choosing their bond investments, both individual investors and the majority of financial advisors simply select an intermediate bond fund or ETF for their exposure. PIMCO Income (MUTF:PONAX) or a "total bond fund" like Blackrock Total Return (MAHQX) or Fidelity Total Bond (FEPIX) tend to occupy the overwhelming majority of the space in fixed income. Even investors who shun mutual funds for their equities tend to be comfortable buying them for fixed income instead of buying individual issues. ETFs, in our opinion the worst way to invest your fixed income, are also prevalent in these portfolios. An example would be Vanguard Total Bond Market (BND).

What often happens when we release a bond-related article on Seeking Alpha's public site is numerous comments that go something like this: "Interest rates are going no where but up, so why own bonds at all?" It's almost as if we are choosing to lose money by holding bond positions.

So why do we hold bonds when its quite clear that rates will rise and we are going to lose money?

Bonds can be split into two categories: interest rate sensitive investments (those with duration), and credit sensitive (shorter duration).

Interest rate (duration) sensitive:

Higher duration (more sensitivity to rising rates) but less chance of default (loss of principal).

Lower yielding, less upside and total return.

Downside protection in a recessionary environment (will still fall but much less)

Example: Treasuries, municipal, agency MBS

Credit sensitive:

Lower duration. Most high yield debt is issued between 5-10 years.

Higher yielding, more upside and total return

Risk of default and loss of principal (high yield default rate topped at 12% in 2009).

Example: Corporates, high yield (junk), floating rate

Right now, credit sensitive investments are all the rave. Most actively managed bond portfolios today are substantially overweight credit and underweight duration. The belief that rates will only go up has led to significant demand for short-term, higher-yielding credits. These are primarily junk bonds with less than 3 years to maturity.

Credit spreads have thus been pressed down significantly (aided by rising oil prices). Spreads are down to the tightest post-recession levels as investors seek out the higher yields of junk bonds but also the interest rate sensitivity.

All the rage today is in the floating rate loan sector. These are securities that adjust the coupon payment every 90 days based on prevailing interest rates. As rates rise, your income rises and the principal balance is unaffected. Compare this to your core bond funds which are underwater YTD as rates rose. This is after everyone suspected rates to rise and portfolio managers positioned for such, reducing the interest rate sensitivity of the portfolio as a whole.

So why not own levered loans (floating rate bonds), which have the least amount of interest rate sensitivity as they are positively correlated to higher rates?

Turn it around. Why would an issuer of debt want to issue floating rate? After a 35-year bull market of falling rates in the bond world, issuers know the risk of rates is to the upside. Companies that need capital to invest would certainly want to lock in these lower rates. For one, it gives them a bit of certainty in their interest costs and for two, if/ when rates rise, they do not want the burden of those higher rates on their balance sheets.

From an issuer standpoint, all else equal, they would first want to issue investment grade corporate bonds with longer maturities to fund their enterprises. If the market will not handle that, than they would move to investment grade with shorter maturities. After that, high yield bonds, and then, floating rate debt. So when an issuer sells floating rate paper, they are doing so because that is the only debt the market will allow.

As a portfolio manager, we want to have adequate risk budgets for our return target. By investing solely in floating rate debt instruments, we are accepting a very low credit quality investment (equity-like) with significant upside potential, in exchange for current interest rate risk. Floating rate, by structure, are non-investment grade (less than 10% is investment grade) with a duration of 0.25 years. In a negative credit event (when defaults rise) like a recession, higher defaults will result along with wider credit spreads, which will result in losses in principal.

But remember, interest rate sensitive investments like treasuries and municipals are there for a reason. They are your downside buffers- insurance that pays you to wait to use it. When their utility arises, your credit investments will likely be suffering as defaults and spreads rise significantly.

The role of the bonds in the portfolio, even those that are interest rate sensitive, help us control the level of risk. They add diversification benefits to our stock allocation reducing the risk-return assumed. Bonds not giving a large amount of return, or even hitting the hurdle rate assumed in financial plans, is often frowned upon. But that is not their job. Their job is allow a reduced volatility and mute the movements of the portfolio keeping you steadfast without making irrational moves.

If long-term compounding of wealth is your goal, simply holding a diversified basket of stocks will clearly be the best way to achieve that objective. The data shows that over long periods of time (> 15 years) stocks always outperform bonds. Since 1929, stocks have returned approximately 10% per year but with significant volatility of around 16%. Bonds have returned about 6.5% with about one-third the volatility.

Many investors think they can weather the volatility of stocks, even when investing in a diversified basket of them like the S&P 500. In individual stocks it is substantially more difficult. For example, if one invested $10,000 into Amazon (AMZN) at its IPO, it would be worth $8.2 million today. However, as Charlie Bilello of Pension Partners notes, those gains didn't come in a linear fashion. They came with significant drawdowns.

And of course, investing in just the S&P 500 would have resulted in a 57% draw down in 2008 and a 49% draw down in the 2000-2002 period. The investor's risk tolerance is their ability to weather principal fluctuation in their portfolios. The greater risk tolerance, the greater ability to stand a stock-only investment portfolio.

But the misalignment of risk tolerance and portfolio allocation can result in substantially poorer results. When building your portfolio for wealth accumulation, matching risk tolerance and your portfolio's risk is a key to achieving that objective. When that matching does not take place, you often see the investor selling at the bottoms and buying at the tops of market cycles. If their portfolio did match their risk tolerance, they would have been able to weather the volatility.

Bonds serve a key role in your portfolio. They help to smooth out returns helping you stay disciplined during market turmoil and generate compounded returns. While stocks are your octane growing your wealth, bonds help mitigate overall risk helping keep your emotions in check.

Financial advisors and astute investors know about the annual Dalbar study. While there are many faults to this study, it does hold some merit. The study shows that it is not really fees nor fraudulent financial advisors that cause under-performance, but a lack of patience to hold investments during bad times and for longer time frames. Matching risk tolerance and portfolio risk is imperative.

The Bottom Line

So why hold interest rate sensitive investments in our portfolio at all? For one, we do not know when or if rates will rise and for how long. The roll of the interest rate sensitive investments is to protect on the downside. If you have to add them after markets have started to unravel, it is likely too late. Accepting losses in the near term for a long-term goal of better risk-return metrics, is something bond investors need to contend with. Otherwise, they are likely to make the same emotions-based trading at EXACTLY the wrong moments in time.

Some of our members select just those positions in the Core and elsewhere, that will play a certain role in their portfolio. We do not have the knowledge they do on their personal finances- so holding a diversified portfolio that is more or less low maintenance, makes a lot of sense.

However, we think a cash flow-based approach to investing is the best way for older investors to approach building their portfolios in retirement. Given the state of the 60/40 portfolio, which we detailed recently, we believe this is a great way to mitigate risk today. Our Core Portfolio is the centerpiece of that approach occupying as much as 35% of the total assets of individuals' portfolios. The income production coupled with other asset strategies and base income (social security, annuities, and pensions) help to create a no or ultra-low (<1.5%) withdrawal portfolio. We believe this is the key!

Here are the returns of the Core Portfolio through the end of May:

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Yield Hunting is a marketplace concept that focuses on finding that best risk-return area of the market for income investors, especially those nearing or in retirement. We focus on a Core Portfolio that aims to provide enough income to support your lifestyle without taking on excessive risks. We provide members with model portfolios, a vibrant and educational chat room, and access to professionals who can help guide you in building a proper portfolio for your risk tolerance. We issue a monthly letter and weekly commentaries used by financial advisors for their clients. For a sample of a past newsletter, please message us on SA.